Krugman's Case For Even More Stimulus Is Even More Erroneous

By David Stockman. Posted On Tuesday, December 23rd, 2014

As distasteful as it can be, there will be, I believe, a necessary condition whereby closer examination of Paul Krugman’s writings and rantings is fruitful. The rise of Keynesian doctrine, more specifically the re-rise, seems to be more and more prevalent especially as the global economy careens out and away from all the trillions in monetarisms that have been perpetrated these past seven years. Part of that is due to Krugman’s assertions, which have been very blunt and emphatic to his credit, that monetarism would not work. Thus what is more important are his prescriptions for what to do next, not as if they will be more effective but rather as instructive as to what further mistakes policymakers will render in the near future.

As this becomes true, his reasoning as to why he believed monetary unsuitability to be the case becomes paramount – namely that monetary “stimulus” without fiscal “stimulus” especially at the zero lower bound is useless. He is of the “liquidity trap” generation, as he diagnoses the current condition as “pushing on a string.”

This was not, apparently, a long-held position for Dr. Krugman, but one in which he converted out of Japan’s “experiment” in the late 1990’s.

To my own surprise, what the model actually said was that when you’re at the zero lower bound, the size of the current money supply does not matter at all. You might think that it’s a fundamental insight that doubling the money supply will eventually double the price level, but what the models actually say is that doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future supplies — and hence raising expected inflation — matters not at all.

That is his explanation as to why even massive QE will not move to inflation at the zero lower bound. To his formulation there needs to be a credible assertion of continually applying the same pressure through QE. Financial agents are not to be fooled by that, as this is all rational expectations theory, because they know (which is debatable) there is a boundary by which a central bank will not pass. In other words, if central banks commit to doubling the money supply to gain inflation, financial agents already know that such a commitment is false and constrained by (what they hope) rational sense not to perpetuate into hyperinflation and collapse.

That is why central banks, particularly the Bank of Japan, instead commit to do whatever it takes – but only to a certain point. By inserting an actual target, the central bank hopes that financial agents will no longer be constrained by their expectations of an end to the monetary expansion because they acknowledge it in the first place. This should sound familiar to anyone familiar with US policy under Bernanke; this is a form of “forward guidance.” It is also circular: you can be assured that we (central banks) are going to act irresponsibly but only to a point, because we acknowledge that point and will then act responsibly you should only consider our irresponsible actions and not worry because we (not you) know where to stop.

In what is gaining Dr. Krugman wider attention inside governmental and policy considerations is that he has been saying all along it doesn’t work on either side of “forward guidance.”

Still, isn’t this just theory? Well, no. Huge increases in the monetary base in previous liquidity trap episodes had no visible effect. And now we have the post-2008 experience, and it’s certainly not an example of central banks easily dealing with economic downdrafts.

That is the problem in coming to the “right” conclusions from the exact wrong direction. None of his formulations encompass the asset bubbles to which he himself has acknowledged (under secular stagnation). There is a far simpler explanation to the lack of “inflation” at the zero lower bound that has nothing to do with convolutions of circular expectations.

QE does not expand the “money supply” but only the quantity of reserves. Economists often consider this as a fungible aspect of modern operation, but it is a central and unyielding distinction. The amount of credit and financialism in any economy is not determined by central bank inputs, especially not directly. The true mechanism of “money supply” and “money printing” is the bank balance sheet which undertakes a whole host of dynamics, not the least of which is “capital” limitations of both accounting notions and the mathematical descriptions of “risk.” This is true not just domestically, but linking the entire global financial system especially through the eurodollar standard which is the purest expression of exactly this specificity.

At the zero lower bound, central banks are enforcing significant repression on returns, which is really the same thing as making bank “capital” highly expensive. Thus financial firms, including the primary dealers that have easiest access to QE’s “reserves”, have high incentive toward speculation and very risky activities. That is especially true during these periods which are almost exclusively dedicated to financial “normalcy” regardless of situation, as then risky behavior becomes self-reinforcing (bubbles!) under the very same “pushing on a string.” Such activities tend not to support a robust economic expansion – but do “support” the appearance and maintenance of asset bubbles.

The problem here is as Dr. Krugman describes but not the reasons for him describing it. The problem really is that none of these economists, including Krugman, seem to have any idea what constitutes actual “money” and financialism. Instead, they rely on vague notions of non-specific conceptions that simply do not apply in the real world of operational finance.

Of course, the deficiency in theory is even more basic since there is no economy in existence that actually gains through intentional currency destruction. Instead, a healthy economy may overcome it, but an economy already suffering the pains of monetarism will not be boosted by it. Redistribution is always a negative (activity for the sake of activity) but Krugman’s “explanations” of the shortcomings on the monetary side are being taken as forgiveness in favor of fiscal redistribution; a logical fallacy that because he was “right” about monetarism being wrong, he will be “right” about fiscal “stimulus” and why it was wrong before. That is our future, at least until policy admits that all redistribution is, at best, futile, and, at worst and sadly most applicable, a heavy and dominating economic drag.

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